Private credit 2024 investment outlook

For most major central banks, the primary objective for 2023 was fighting inflation while simultaneously maintaining financial stability. They appear to have done this with some degree of success so far, despite challenges earlier in the year when Silicon Valley Bank and Credit Suisse triggered temporary concerns.

Indeed, price rises have slowed sufficiently to allow the Fed, the European Central Bank and the Bank of England to pause rate hikes in recent months. Furthermore, growth in all three regions proved more resilient than expected over the course of the year.

That said, it remains clear that underlying pressures persist. With this in mind, markets are adjusting to the realisation that interest rates are likely to remain higher for a longer period than initially anticipated. Furthermore, we are likely to see slowing economic growth across regions in 2024, as the impact of higher interest rates starts to bite.

Against this backdrop, we sat down with experts from Invesco’s bank loans, direct lending and distressed credit teams. They shared their views on what we can expect from 2024.

Bank loans: coupon levels are near all-time highs

Kevin Egan, Senior Portfolio Manager, Senior Secured Bank Loan Group

It is important to start by acknowledging today’s unstable geopolitical landscape. The troubling conflict in the Middle East has added an additional degree of uncertainty to the investment backdrop.

Our outlook is based on the assumption that the conflict will remain relatively contained, rather than spilling over and significantly altering the operating environment for loan issuers. However, we continue to watch this closely.

Overall, we believe 2024 will be another strong year for loan returns. Coupon levels are near all-time highs and will remain at these levels until central banks pivot aggressively towards lowering rates.

While an aggressive easing cycle is possible based on historical experience, it is not our base case. Furthermore, even if this environment were to materialise, it would not materially diminish loan coupons until late 2024. 

One thing to watch out for is the impact of a challenging economic environment on company performance. The lagged effects of monetary policy tightening may result in a less supportive macroeconomic and earnings backdrop, particularly for lower rated loans.

That said, we expect the rise in credit stress to be contained. Indeed, default rates are likely to sit at around 3.75-4.25%, in our view. This is in line with long-term averages.

It is also important to remember that most bank loans have “senior secured” status and sit at the top of the capital structure. Historically, this has translated into relatively high recovery rates (60-70%) compared to other subordinated asset classes, for example high yield bonds (30-40%).

At Invesco, we use our credit expertise to carry out in-depth fundamental analysis. Our private-side orientation gives our research team an informational advantage when evaluating issuers, which helps further reduce the risk of defaults. 

Direct lending: historically attractive yields with conservative structuring 

Ron Kantowitz, Head of Direct Lending

Direct lending refers to directly originating senior secured floating rate loans to middle market companies without an intermediary investment bank. Because these are smaller transactions, direct lending loans tend to be buy-and-hold assets and less liquid relative to broadly syndicated bank loans. For this lower level of liquidity, direct lending loans have historically offered a generous 200-300 basis points of additional yield potential. Additionally, direct lending loans tend to be less impacted by public market volatility.

In this environment, we believe direct lending continues to be well-positioned from an income potential and structuring perspective. Over the past 24 months, the Federal Reserve has raised its benchmark rate 11 times to a 22-year high of 5.5%. Furthermore, Chairman Powell’s most recent comments confirmed the Fed’s steadfast stance of “higher for longer”. These actions have increased direct lending’s return opportunity considerably. As floating rate assets, direct lending yields (unlevered) have increased on average from 7.5-8.0% to historically attractive levels of 12-13%.

While higher yields for the asset class can put additional pressure on borrower free cash flow, it’s important to note that the structuring dynamics of direct lending transactions have become more conservative. Leverage levels, or the amount of debt borrowers assume on new transactions, have significantly declined. Meanwhile loan-to-value (LTV) metrics have meaningfully improved whereby first-loss equity position supporting direct lending loans has increased to ~60%.

Lastly, lender influence on documentation has evolved further as more loans are being underwritten with two or more financial maintenance covenants versus one. These structuring elements along with conservative “base case” assumptions account for and provide appropriate cushion to absorb the “known” risks. 

Distressed credit: several tailwinds point towards an enhanced small cap distressed opportunity set 

Paul Triggiani, Head of Distressed Credit and Special Situations

Small companies often run into problems, regardless of economic conditions. This is one of the main reasons that we focus on them in our distressed credit and special situations portfolios. It creates an evergreen opportunity set and allows us exposure to companies across a diverse range of industry sectors.

Furthermore, we believe the current macroeconomic environment should only enhance our landscape. Firstly, we have witnessed tremendous growth in the size of non-investment grade credit markets to ~$6 trillion. Going forward, only modest default rates will be required to result in a significantly larger distressed opportunity set than we saw during the global financial crisis. 

Interestingly, the composition of this growth has included significant percentages of lower-rated and small cap recent issuance, as well as debt scheduled to mature by 2027. Much of this debt may face rating agency downgrades and subsequent selling pressure – potentially offering attractive distressed entry points.

Furthermore, most of these companies carry floating rate debt liabilities and have felt increased pressure from central bank actions. We have observed the impact of this on the ability of small cap companies to cover their fixed charges. Their fixed charge coverage ratios (FCCR) have fallen 21% to 1.1x (from 1.4x) on average. Furthermore, the percentage of companies with FCCR below 1.0x – a threshold connoting that distress may be on the horizon – has jumped from 21% to 31% as of the second quarter of this year.

Lastly, recognising that current capital structures may be unsustainable, the financial owners of these companies have increasingly sought out flexibility. For example, some have amended governing debt documentation and explored alternative options to procure liquidity and secure maturity extensions. These special situations can offer investors opportunities to extract favourable economics and ultimately attractive return potential.